Global FX Regulation

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The Foreign Exchange (FX) market is currently under the microscope.
Regulatory agencies from Switzerland, Germany, Europe, US, UK and Australia are investigating how the FX market works in practice and whether it’s prudent to regulate it globally.
The causes for this sudden regulatory interest have been brewing for several years, although the straw that broke the camel’s back has arguably been the recently discovered cases of widespread FX manipulation at most (if not all) large banks globally.
The FX market differs from all other asset classes in that in its current form, it is completely unregulated, operates over-the-counter, which means there is no central marketplace, and is by far the largest by capitalization.
So as regulators ponder ways to regulate this market, they first have to quantify and ring-fence its reach.

Easier said than done

This is incredibly difficult to do because large currency transactions can take place as part of everyday life (property investment for example) and given fluctuating currency rates, people effectively speculate on currency movements without even being aware of it. With other asset classes this doesn’t apply.
Spot FX transactions are not regulated in any country, despite the assumption that the FCA, NFA, ASIC and others regulate financial services and by extension, the FX market which is part of the financial services landscape.
In fact, what is actually regulated are FX derivatives such as CFDs, Futures and Options. In the case of the Financial Conduct Authority (FCA), spot FX contracts are not qualifying investments under The Financial Services and Markets Act (FSMA) and therefore, FX dealing cannot apply to the market abuse regime under and the FCA’s Code of Market Conduct guidelines. 

Muzzled but Motivated

Despite the jurisdictional quagmire, some attempts have been made to reduce market abuse and mistreatment of private retail investors. The Commodities and Futures Commission (CFTC) created a special task force in 2008 to reign in unscrupulous brokers and introduced harsh penalties in 2010 to protect retail FX traders.
One measure the CFTC was keen to implement is lowering leverage on FX trading accounts for retail clients in a bid to reduce risk taking. However, the measure made FX trading unaffordable for many traders because lower leverage meant higher margin requirements and higher initial deposits.
The knock-on effect has been for U.S traders to seek trading accounts elsewhere around the globe with lower margin requirements. Regulators seem to be creating bit-part solutions which human nature and technology find a way of avoiding before the ink is even dry on the regulatory amendment.
In the UK and Europe, regulation is limited and leverage is unrestrained with 500:1 still available depending on the broker and your trading style. Japan’s ‘Financial Services Agency’ (FSA) reduced the maximum leverage in 2011 from 50:1 to 25:1 having lowered it the year before from 100:1 to 50:1. In a similar vein, increasing numbers of Japanese traders have since looked abroad for a ‘suitable’ broker.
Quite ironic because regulators see margin FX trading as ‘unsuitable’ for many retail investors. It seems that when it comes to leverage and risk-taking, the majority of investors/traders do not want to be restricted or ‘protected’ by regulatory guidelines and rules.

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Too small for safety or too small to matter?

Is it cynical to ask whether the 5%-10% market share occupied by the retail FX industry has any bearing on regulators’ priorities? With so many other financial market practices under scrutiny, do regulators have the resources to regulate the FX market as well? If they’re struggling to keep up with the current workload without FX, how does adding FX to their coverage help anyone aside from stretching existing resources further?
Top-tier banks have demonstrated an insatiable urge to circumvent legislation and anti-competitive safeguards including regulatory oversight in a variety of ways, including manipulating prices in most major asset classes – even FX, the largest market globally by volumes traded each day.
The assumption that additional regulation in the form of a ‘co-ordinated global FX policy’ will therefore stop collusion amongst the largest FX market participants is probably wishful thinking.

MiFID and EMIR to the rescue?

The ‘MiFID II’ directives introduced in 2011 and updated in April 2014 attempt to deal with OTC markets, but there is no specific mention of spot FX. In any case, MiFID II is more so about aligning organizational requirements rather than policing the FX market.
The European Market Infrastructure Regulation (EMIR) is another scheme designed to standardize reporting and clearing in the FX market. However, both MiFID and EMIR focus on larger firms, which means smaller firms can continue offering trading services without being fully compliant with the new regulations..
Unless an authority of some description stipulates that all FX brokers must meet EMIR/MiFID standards or be prevented from operating, the new rules will only add a layer of bureaucracy, fail to necessarily stop collusion, not necessarily make the FX market more transparent and not necessarily protect retail customers. The only likely effect is tougher conditions for smaller brokers to obtain a perceived ‘stamp of authenticity’ and encourage consolidation within the FX industry.
Global regulation of the FX market could reduce the 80% market share top-tier banks hold in terms of FX volumes, but fundamentally, those that transact the most FX business (banks) will always have an opportunity to ‘fix’ benchmark prices from which other financial instruments are derived because they are the de-facto market makers. Regulation cannot stop market abuse but only redistribute its source.
The LIBOR, ISDAfix and FX (amongst many other) manipulation cases demonstrate that given enough market share, large firms tend to form cartels and ‘oligopolise’ amongst themselves, because this reduces operational costs, raises revenues and keeps barriers to market entry high for new participants.
The root of the problem is incentives rather than opportunity i.e. regulation will never take away people’s ability to cheat, it may only take away the incentive to do so.
Given the lack of criminal proceedings relating to any given market abuse inquiry, it seems the incentive not to manipulate a particular market is outweighed by the incentive to do so – this would explain why almost all asset classes have experienced multiple cases of market manipulation emanating from banks. If the only penalties are relatively small fines and individual bans, banks are more inclined to continue manipulative practices seeing as the rewards are incredibly lucrative.
Mifid II is expected to improve upon Mifid I — while an overarching European Banking Union is expected to set forth key changes that will bring regulation closer towards central banks than ever before. The UK’s Bank of England is already taking on more of this type of responsibility within the UK, and the Swiss National Bank (SNB) in Switzerland – subject to market developments of course.
Regulators continue to struggle to even define their jurisdictions and scope; while market participants invent ever more ingenious ways to become undefinable.

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